In the current financial markets, there are two basic studies of commerce: microeconomics and macroeconomics.
This lesson will look at how the latter impacts the foreign exchange markets. After we’re done, you’ll be one step closer to being a well-rounded, successful forex trader.
Read on to learn more about the many interrelationships between macroeconomics and the forex markets.
Macroeconomics is the study of how economies, markets, or industries function on a broad scale. As it pertains to conventional finance, macroeconomics quantifies a financial system’s performance. This is done via the scrutiny of three foundational elements: output, employment, and inflation.
Make no mistake — if you’re trading forex, then you’d best brush up on your Macroeconomics 101!
Economic output is the total value of all produced goods and services. One premier measure of output is Gross Domestic Product (GDP). GDP is viewed in relative terms, typically on a quarterly or annual basis.
In foreign exchange trading, the output is a key market fundamental. It is viewed from two perspectives: performance and growth. Performance is the current measure of output, while growth is the projected measure of future output.
An example of the performance/growth dichotomy may be observed by looking at Nominal GDP and Real GDP. Nominal GDP is the total value of all goods and services produced during a specified period; Real GDP accounts for inflation by using constant pricing (more on inflation in a minute!).
Nominal and Real GDP are key elements of trading forex as both serve as performance and growth indicators. Generally, when GDP values are positive, the exchange rate of the domestic currency appreciates. Conversely, the local currency lags versus other foreign currency values when GDP is negative.
For all economies, developed and emerging, unemployment levels are a vital macroeconomic indicator. Various metrics are used to measure unemployment. A few of the best-known among forex traders are the U.S. Non-Farm Payrolls report and the U.K. Unemployment Rate.
Generally speaking, employment levels and domestic exchange rates have a negative correlation. As a country’s unemployment grows, the domestic currency loses value. Why? There are two fundamental reasons:
If you’re going to trade the forex market, don’t forget about unemployment! It is an excellent signal for understanding the macroeconomic state of a country, region, or the world as a whole.
Inflation is a complex topic that has a collection of unique definitions. Perhaps the most common description is an upward movement in the pricing of an economy’s goods and services. When inflation rises, so do producer and consumer prices.
For this discussion, we won’t get lost in the weeds talking about classical demand-pull and cost-push inflation. When we trade foreign exchange pairs, here’s what we need to know: inflation causes pricing instability and devalues the domestic currency. So, when an economy experiences inflation, the local currency loses its value.
Inflation is a significant factor to consider in any study of the global capital markets. And, like unemployment, central banks are tasked with ensuring pricing stability. Authorities like the Fed or BoE raise interest rates and limit the availability of credit to hold inflation in check.
Generally, when central banks attack inflation by raising interest rates, the domestic currency appreciates. So, when the Fed hikes rates, the USD is positioned to rally across the currency markets. Why? Because people are incentivized to deposit money and refrain from borrowing.
It makes sense, right?
The whole point of applying macroeconomics to the currency markets is to make money trading foreign exchange pairs! Or else, what’s the point? Why go to the trouble of scrutinizing interest rates, unemployment figures, and GDP?
The truth is that macroeconomics is a crucial element of fundamental analysis. Accordingly, there are countless fundamental trading strategies based on this area of study. Below are two:
The release of official metrics such as GDP or Non-Farm Payrolls typically brings enhanced volatility to the markets. Amid such releases, many forex traders buy or sell currency pairs in reaction to the hard data. Also, technical momentum, trend, or reversal strategies are frequently applied to the enhanced price action.
During periods of economic uncertainty, forex players often take positions based on what they believe central banks are going to do. For instance, during a period of explosive U.K. economic activity and inflation, a trader may buy the GBP in anticipation of the BoE hiking interest rates.
Remember, there are many ways to make money in the forex markets. The foreign exchange strategies above are only the tip of the iceberg!
As with any strategy or discipline, there are a few things that you must do to make macroeconomic analysis work for you. Two of the most important are to think forex and be consistent.
It doesn’t do much good to become an expert on international trade if you don’t understand how it impacts exchange rates. All the macroeconomic data in the world is useless if you can’t apply it to the foreign exchange market. That’s why it’s critical that you not only digest financial information but always ask the question, “how will this information impact the forex?”
Before diving into an economic release or a country’s financials, think about how the data set can impact that country’s currency. For instance, if you’re trading the Canadian dollar (CAD), it helps to have at least a basic understanding of Canada’s key imports, exports, goods, and services. If not, the economic information can quickly become “number soup.”
Regardless of analysis or strategy, you must be consistent with your methodology. This also applies to the study of macroeconomics. If your research varies from currency pair to currency pair, it will become challenging to understand the “whys” behind exchange rate fluctuations.
At this point, you may be wondering how to stay consistent with macroeconomic analysis. One way is to always compare apples to apples. If you compare Zimbabwe’s GDP to U.K. unemployment when trading the GBP/ZWD, your analysis is inherently flawed. Here’s why:
Add it all up: the macroeconomic analysis above is apples to oranges. If you’re trading the GBP/ZWD, then note how Zimbabwe’s GDP, inflation, and unemployment is performing relative to its past. Then, do the same for the U.K. and begin looking at how the GBP/ZWD exchange rate has evolved over time.
Always compare apples to apples! By doing so, you can become a consistent macroeconomic guru!
One of the most powerful tools that forex traders around the world use are macroeconomic analysis. Studying market drivers such as inflation, unemployment, and industrial growth can give us invaluable insights into exchange rate fluctuations.
However, when you conduct your analysis, remember to do two things: think forex and compare apples to apples. By doing so, you can apply what you have learned and consistently cash in on differences in exchange rates! Macroeconomics is only one facet of fundamental analysis. Move on to the next lesson to learn more about forex fundamentals and how they impact currency exchange rates.
Mimic how professionals trade. Discover your inner talent. Learn everything you need to know about trading the markets from beginner level to the most advanced, helping you to create critical skills and techniques to you can apply in your trading right away.
Mimic how professionals trade. Discover your inner talent.
Learn everything you need to know about trading the markets from beginner level to the most advanced, helping you to create critical skills and techniques to you can apply in your trading right away.
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